The Ketchup-Holding Tolerance of the Market Is Much too Low and Much too Volatile...

[Consider] a field of economics which could exist but does not: ketchup economics: There are two groups of researchers concerned with ketchup economics. Some general economists study the market for ketchup as part of the broader economic system. The other group is composed of ketchup economists located in a Department of Ketchup where they receive much higher salaries than do general economists. Each group has a research program.

General economists are concerned with the fundamental determinants of prices and quantities in the ketchup market. They attempt to examine various factors affecting the supply and demand for ketchup such as the cost of tomatoes, wages, the prices of ketchup substitutes, and consumers incomes. They examine a number of different types od data in an effort to explain fluctuations in ketchup prices. The models that are estimated have some successes in explaining price fluctuations but there remain puzzles.

Ketchup economists reject out of hand much of this research on the ketchup market. They believe that the data used is based on almost meaningless accounting information and are quick to point out that concepts such as costs of production vary across firms and are not accurately measurable in any event. they believe that ketchup transactions prices are the only hard data worth studying. Nonetheless ketchup economists have an impressive research program, focusing on the scope for excess opportunities in the ketchup market. They have shown that two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup except for deviations traceable to transaction costs, and that one cannot get a bargain on ketchup by buying and combining ingredients once one takes account of transaction costs. Nor are there gains to be had from storing ketchup, or mixing together different quality ketchups and selling the resulting product. Indeed, most ketchup economists regard the efficiency of the ketchup market as the best established fact in empirical economics.

The parallels should be clear. Financial economists... work only with hard data and are concerned with the interrelationships between the prices of different financial assets. They ignore... the more important question of... the overall level of asset prices. It would surely come as a surprise to a layman to learn that virtually no mainstream research in the field of finance in the past decade has attempted to account for the stock market boom of the 1969s or the spectacular decline in real stock pries during the 1970s.

General economists... may be asking the right questions but they will frequently lack the right data to answer them. Indeed, it may not be possible to construct tractable models that account for... price fluctuations. But this... establish[es]... only the inadequacy of current data, theory, and empirical methods.

Neither... approach... has a unique claim to virtue. Rather they are complementary....

Tremendous controversy has raged over the past several years as to whether or not the stock market is excessively volatile.... Shiller concluded that fluctuations in expected future dividends could account for only a small part of the variance in stock prices. This conclusion has been savagely attacked.... The volatility test controversy is like a scientific debat about whether one can reject the hypothsis tht the earth is flat with a microsoft. Shiller's conclusion that the joint hypothesis of rationaliaty and a constant required real return... can be rejected is exactly the conclusion reached by most modern work... the null hypothesis that the real ex ante rate is constant can be rejected at almost any level of confidence. Ahillr's conclusion is exactly consistent with this result.

Why then has work on volatility testing generated such hostility?... In part because [of]... intrpret[ations of]... rejections... in controversial ways. In part because... [of] interesting and complex methodological issues. But a large part... [is] a deep distrust of work purporting to explore fundamentals valuations.... To what extent do fluctuations in stock prices reflect changes in risk premia, safe rates of return, expected future cash flows, or other factors?... [S]tandard approaches... emphazi[zing]... the determinants of ex ante returns are ill-suited to these important questions.

The increasing disjunction... [is] obviously inefficient.... We can do better.

As I understand things:

The lion's share of the fluctuations in the dividend yields of individual stocks are due to changes in not-unreasonably-anticipated future cash flows.

The lion's share of the fluctuations in the dividend yield of the market as a whole are due to changes not in safe real interest rates or changes in future growth rates but rather to long-run fluctuations in the overall risk tolerance of the market.

On average, the risk tolerance of the market is much too low to make sense.

Comments

[Consider] a field of economics which could exist but does not: ketchup economics: There are two groups of researchers concerned with ketchup economics. Some general economists study the market for ketchup as part of the broader economic system. The other group is composed of ketchup economists located in a Department of Ketchup where they receive much higher salaries than do general economists. Each group has a research program.

General economists are concerned with the fundamental determinants of prices and quantities in the ketchup market. They attempt to examine various factors affecting the supply and demand for ketchup such as the cost of tomatoes, wages, the prices of ketchup substitutes, and consumers incomes. They examine a number of different types od data in an effort to explain fluctuations in ketchup prices. The models that are estimated have some successes in explaining price fluctuations but there remain puzzles.

Ketchup economists reject out of hand much of this research on the ketchup market. They believe that the data used is based on almost meaningless accounting information and are quick to point out that concepts such as costs of production vary across firms and are not accurately measurable in any event. they believe that ketchup transactions prices are the only hard data worth studying. Nonetheless ketchup economists have an impressive research program, focusing on the scope for excess opportunities in the ketchup market. They have shown that two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup except for deviations traceable to transaction costs, and that one cannot get a bargain on ketchup by buying and combining ingredients once one takes account of transaction costs. Nor are there gains to be had from storing ketchup, or mixing together different quality ketchups and selling the resulting product. Indeed, most ketchup economists regard the efficiency of the ketchup market as the best established fact in empirical economics.

The parallels should be clear. Financial economists... work only with hard data and are concerned with the interrelationships between the prices of different financial assets. They ignore... the more important question of... the overall level of asset prices. It would surely come as a surprise to a layman to learn that virtually no mainstream research in the field of finance in the past decade has attempted to account for the stock market boom of the 1969s or the spectacular decline in real stock pries during the 1970s.

General economists... may be asking the right questions but they will frequently lack the right data to answer them. Indeed, it may not be possible to construct tractable models that account for... price fluctuations. But this... establish[es]... only the inadequacy of current data, theory, and empirical methods.

Neither... approach... has a unique claim to virtue. Rather they are complementary....

Tremendous controversy has raged over the past several years as to whether or not the stock market is excessively volatile.... Shiller concluded that fluctuations in expected future dividends could account for only a small part of the variance in stock prices. This conclusion has been savagely attacked.... The volatility test controversy is like a scientific debat about whether one can reject the hypothsis tht the earth is flat with a microsoft. Shiller's conclusion that the joint hypothesis of rationaliaty and a constant required real return... can be rejected is exactly the conclusion reached by most modern work... the null hypothesis that the real ex ante rate is constant can be rejected at almost any level of confidence. Ahillr's conclusion is exactly consistent with this result.

Why then has work on volatility testing generated such hostility?... In part because [of]... intrpret[ations of]... rejections... in controversial ways. In part because... [of] interesting and complex methodological issues. But a large part... [is] a deep distrust of work purporting to explore fundamentals valuations.... To what extent do fluctuations in stock prices reflect changes in risk premia, safe rates of return, expected future cash flows, or other factors?... [S]tandard approaches... emphazi[zing]... the determinants of ex ante returns are ill-suited to these important questions.

The increasing disjunction... [is] obviously inefficient.... We can do better.

As I understand things:

The lion's share of the fluctuations in the dividend yields of individual stocks are due to changes in not-unreasonably-anticipated future cash flows.

The lion's share of the fluctuations in the dividend yield of the market as a whole are due to changes not in safe real interest rates or changes in future growth rates but rather to long-run fluctuations in the overall risk tolerance of the market.

On average, the risk tolerance of the market is much too low to make sense.

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